a forum for news, ideas and commentary on the art and science of long-term investing

Why Bond Yields Scare Me More Than Friday the 13th

Stock investors generally don’t have much to fear on Friday the 13th. Historically, Friday the 13th is a relatively calm day for stocks. Jason Zweig, who writes The Wall Street Journal’s Intelligent Investor column, says it’s usually a good day for investors and says superstition about trading on this supposedly unlucky day is one of the market’s “dumbest myths.”

Current Bond Yields: A Bad Omen?

Among the most-watched reference numbers in the markets these days are Treasury bond yields. Along with yields on our own government’s bonds, investors can also gather important information from the yields on government bonds issued by other nations. Currently, ten-year Treasury bonds have a yield of below 1.5%. The official U.S. rate of inflation, as measured by the Consumer Price Index (CPI) is 2.3%. What this means is that investors in Ten-Year Treasury bonds can expect to see their purchasing power decline because the yield on the bonds is less than the rate of inflation.

Global Bond Yields Slashed

The decline in the yields on U.S. bonds has been mirrored in the bond yields of the stronger Euro-zone countries. Germany’s two-year bonds recently saw their yields drop below zero. This means that investors are paying to lend Germany money. While U.S. two-year Treasury yields offer a paltry 0.25% yield, there is a meaningful difference between positive and negative yields. Let me quickly explain: If you hold cash, you receive 0% yield. A negative yield means that you are losing money relative to holding cash. (For a further explanation of the factors that drive bond yields, you’ll want to read, “What Historically Low Treasury Yields Say About The Economy”).

Simply put, this current yield environment is scary. Now, there are a couple of different ways to explain theses incredibly low yields. One is that we have a ‘bond bubble’ in which investors are pouring money into bonds because bonds have generated very positive returns in recent years. (For those of you not familiar with the term, a bond bubble forms because investors keep making the same bet in increasingly large amounts, and ignore fundamentals, because this bet has worked out in recent years.)

A prime example? Think back to the late 1990s when the prices of tech stocks were far above any rational valuation. Investors kept buying tech stocks because the trailing years’ returns had been stellar. Eventually fundamentals (specifically, corporate earnings) served as an anchor that brought tech stocks back to a rational level of pricing.

This same argument has been made with respect to bonds. The trailing 15- and 5-year annualized returns for Vanguard’s Short-Term Bond Index Fund (VBISX) are 4.9% and 4.7%, respectively. The trailing 15- and 5-year annualized returns for Vanguard’s S&P 500 Fund, the Vanguard 500 Index Investor (VFINX) is 4.7% and 0.4%, respectively. Investors may simply be betting that what outperformed (i.e., bonds) will continue to out-perform, regardless of fundamentals.

This is bubble logic.

The fundamental variables that matter with government bonds are default risk, inflation risk, and yield. Default risk is the risk that the government does not make good on its bonds. Investors are discounting inflation risk entirely and are, in some cases, actually paying to lend money to the countries with the lowest default risk (Germany and Switzerland in Europe, for example). In the process, they are betting that inflation risk is low. This reasoning is the only way to explain that investors are willing to buy government bonds at the current exceedingly low yields.

A New Normal or Bond Bubble …or Both?

PIMCO’s Mohamed El-Erian believes that we are not in the midst of a bond bubble. Bond yields can be considered as a consensus view of expected future economic growth. If investors, as a whole, feel that economic growth potential is low—or that the global economy is likely to contract—they are more likely to look to government bonds than to investments such as stocks.

In slow-growth or contracting economic conditions, safe low-yields look more attractive relative to higher-risk investments that will perform well only if the economy is growing. El-Erian and Bill Gross have been predicting a ‘New Normal’ in which economic growth is far below the levels to which we have become accustomed since World War II. Rather than a bond bubble, it may be that we are seeing the market move towards the ‘New Normal’ outlook. In such an environment, low yields might be quite rational. On the other hand, Gross has recently suggested that the current very low yields on U.S. Treasuries may, in fact, reflect an economy that is at a ‘breaking point.’ He believes—and has for some time—that U.S. Treasury bond yields are not high enough to justify the risks.

Bond Investors Being Superstitious

We are in an environment in which investors are seeking safe havens for their money, and turning their backs on riskier assets. U.S. Treasury bonds and government bonds issued by the strongest Euro-zone governments are perceived as the ultimate ‘safe haven’ investments.

I agree with these investors that they are essentially guaranteed to receive their promised interest payments and the return of principal. The problem, however, is that these dollars or Euros (or other currencies if the Euro fails) are quite likely to provide no gains at all versus inflation, and there is an increasing risk of negative returns in terms of purchasing power. When returns are judged in terms of the excess beyond the rate of inflation, this is referred to as real return. Assuming that we can ignore default risk of the U.S. government, investors should expect to generate a return on Treasury bonds equal to the bonds’ yield. When the yield of ten-year bonds is 1.5%, investors will generate a positive real return only if inflation is below 1.5%. The ‘margin of safety’ for receiving positive real return declines with yield.

For retirees and others who are relying upon the yield generated by government bonds as a source of income, the current historically low rates are a nightmare. Trying to live on 1.6% yield when inflation is 2.3% means that you are losing real wealth each and every year. The even worse news is that yields can go lower. Japanese ten-year bond yields are 0.8% and there are those who believe that this is the direction that U.S. yields are going.

About Geoff Considine

After earning his Ph.D. in Atmospheric Science, Geoff worked for NASA for 3 years, leaving to become a quantitative analyst developing trading and portfolio management solutions for an energy trading firm. In 2000, Geoff became a consultant focusing on quantitative methods in portfolio management. Geoff founded Quantext in March 2002.
Geoff has published commentary and analysis in a range of publications.
Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com (http://www.foliofn.com)).
Neither Quantext nor Geoff Considine is an investment advisor.

What Type of Investor Are You?

Understanding your investing profile to achieve your financial goals starts with a few simple questions. The Investor Questionnaire, by Folio Investing, will help you understand your investment time horizon, investor profile and level of risk.